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Reforming the International Financial System for Development$

Jomo Kwame Sundaram

Print publication date: 2011

Print ISBN-13: 9780231157643

Published to Columbia Scholarship Online: November 2015

DOI: 10.7312/columbia/9780231157643.001.0001

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Reforming Financial Regulation

Reforming Financial Regulation

What needs to be done

(p.143) 6 Reforming Financial Regulation
Reforming the International Financial System for Development

Jane D’Arista

Stephany Griffith-Jones

Columbia University Press

Abstract and Keywords

This chapter calls for a careful consideration of the agenda and criteria for financial regulatory reform in view of the differing circumstances, experiences, capacities, and capabilities of various economies in the international financial system. The global financial crisis that started in 2007 follows many costly crises in developing economies over the last three decades. Like previous ones, it is the result of inherent flaws in the way financial markets operate coupled with insufficient, incomplete, and sometimes inappropriate regulation. This chapter argues that liberalization of financial markets has been a major cause of costly crises, especially in the last two decades. With the emergence of a shadow banking system, which remains opaque and unregulated, the chapter suggests that regulatory reform needs to be comprehensive in order to avoid regulatory arbitrage and should also strive to be countercyclical to try to compensate for the inherently pro-cyclical behavior of financial markets. It also proposes some key criteria for reforming financial regulation involving capital provisions and liquidity requirements, taking into account the perspectives and needs of developing countries.

Keywords:   international financial system, financial crisis, financial markets, liberalization, shadow banking, regulatory reform, financial regulation, capital, liquidity, developing countries

The more free-market oriented our economy, the greater its need for official financial supervision.

Henry Kaufman, Financial Times, 6 August 2008

A short look at history indicates that, unless governed by appropriate regulation, financial markets tend to cause costly and damaging crises. This does not imply that financial crises are inevitable; they can, in fact, be prevented, or ameliorated, by appropriate public policy and, especially, by regulation.

After the Great Depression, the financial sector—particularly, but not only in the US—was re-regulated for soundness by adopting such measures as the US Glass-Steagall Act of 1933. During the next forty years, with the global financial sector highly regulated and capital accounts fairly closed, there were practically no financial crises. In the 1970s, and especially during the 1980s and 1990s, there was massive de-regulation, both at national and international levels. Since the 1980s, there have been very frequent and very deep financial crises, both in the developing and developed world. These have been extremely costly in terms of growth and development.

The only silver lining that appears during these costly crises is that they provide a political opportunity to carry out desirable regulatory reforms. The depth of the current crisis in the developed economies represents such an opportunity. It has led to massive bail-outs, public recapitalizations of many financial institutions and large costs to taxpayers which generated a great deal of anger. The crisis threatens to lead to an (p.144) unacceptably serious and possibly long recession globally. Developing economies, though innocent bystanders, have been seriously affected. As a consequence, there is significant political appetite for more and better regulation. Furthermore, it is increasingly clear that effective regulation is not just in the interests of the real economy; it is also critical for the stability and competitiveness of the financial system itself, as well as of individual financial institutions.

The key question in policy circles at present is therefore not whether to regulate, but how best to do it. In thinking about the future shape of the financial system and its regulation, it is important to be clear about its purpose. The financial sector should be seen as a means to an end: it should serve the real economy, and thus the needs of households and enterprises to consume and invest. While governments should encourage the financial sector to innovate and create instruments that support growth and development in a sustainable way, they should also use regulation to dampen the potential for systemic risk. Future crises must be prevented because of their impact on lost output and investment and, above all, on the lives of people, many of whom are poor and bear no responsibility for what has occurred.

The global financial crisis that started in 2007 follows many costly crises in developing economies over the last 30 years. Like previous ones, it is the result of both inherent flaws in the way financial markets operate—such as their inherent tendency toward boom-bust behavior—and insufficient, incomplete and sometimes inappropriate regulation. The new systems of financial regulation should attempt to deal with these problems as well as the emergence of new and unregulated actors and instruments, and increased globalization of financial markets. To do this adequately and to avoid regulatory arbitrage, regulation has to be both comprehensive and countercyclical. These two broad principles—comprehensiveness and counter-cyclicality—provide the framework for our proposals detailed below.


In order for regulation to be efficient, it is essential that the domain of the regulator is the same as the domain of the market being regulated. Furthermore, lender-of-last resort type facilities, provided by national central banks and the European Central Bank are increasingly being extended to new actors and instruments during the current turmoil. As a result, a corresponding expansion of regulation to actors and activities (p.145) that have been, or are likely to be, bailed out, is essential to avoid moral hazard. The internationalization of lender-of-last resort facilities seems both inevitable and desirable, given European and globalized private financial players, but needs to be accompanied by a strengthening of the international dimension of financial regulation to prevent the growth of financial activity and risk-taking in areas where international regulatory gaps exist. Thus, we see a global regulatory institution as an essential condition to efficiently implement comprehensive international regulation of institutions that engage in international transactions. Such an institution would be particularly desirable from the perspective of developing countries if they are appropriately and effectively represented in such international regulatory fora.

The necessary pre-condition for comprehensive regulation is transparency. It should be required of all actors and activities and entail registration of relevant variables for all financial institutions. Requiring transparency will benefit other financial market participants and investors, as well as macroeconomic authorities.

Instituting comprehensive and equivalent regulation will require covering all entities that invest or lend on behalf of other people, and all activities which they undertake. Such regulation needs to be done in ways that protect both liquidity (by imposing liquidity requirements on individual institutions as well as required reserve holdings by all institutions with national or regional central banks), and solvency (based on capital requirements that would significantly improve and modify the existing Basel banking regulatory framework, while widening solvency requirements to other financial institutions). Adequate liquidity and capital buffers are, in fact, linked as sufficient reserves—implying higher levels of liquidity in individual institutions and in the whole system—will alleviate pressure on capital in times of stress.


The pro-cyclical behavior of most financial actors leads to excessive risk-taking and financial activity in good times, followed by insufficient risk-taking and financial activity in bad times. As a consequence, regulation needs to be countercyclical to compensate for the inherent pro-cyclical behavior of capital and banking markets. This implies varying regulatory requirements for reserves, loan to asset value ratios, capital, provisioning against losses, etc. according to the phase of the economic cycle. Regulatory requirements such as capital or reserves could thus be varied according (p.146) to the growth of total assets, and/or the expansion of assets in particular sectors, e.g. loans for housing. As former BIS Chief Economist, William White (2007) pointed out, this would use “monetary and credit data as a basis for resisting financial excesses in general, rather than inflationary pressure in particular.”

The next section briefly outlines the lapses in regulation of systemically important institutions in the advanced economies seen as the primary causes of the crisis, and how the problems generated were transmitted to developing economies. In the following section, we develop what we believe are the key principles and criteria for a regulatory framework that minimizes systemic risk. The concluding section develops our main regulatory proposals for liquidity and solvency.

Channels for Crisis Transmission: Lessons for Reform

In April 2009, the G20 meeting and the Financial Stability Board both agreed that the failure or absence of appropriate financial regulation were major causes of the crisis. Some of the factors seen as among the most damaging include:

  • excessive leverage funded by short-term borrowing;

  • changes in the structure of the financial system that increased the volume and importance of marketable assets relative to loans and resulted in what the Financial Stability Board (2009) characterizes as “extensive application of fair value accounting”;

  • the proliferation of opaque, non-public markets for asset-backed securities and derivatives;

  • off-balance sheet operations that eroded regulatory constraints and systemic transparency and depleted capital reserves;

  • unconstrained growth in global debt; and

  • deceptive lending and fraud.

Like the sub-prime mortgage crisis itself, these are factors that originated in markets and institutions located in advanced economies. But they contributed to developments that, in time, precipitated losses for the financial sectors and economies of countries far removed from the sources of the problem as capital flows to developing economies drew these countries into the web of speculation that institutions in the advanced economies created. Preventing a repetition of the disturbances they precipitated is critical for the future growth and prosperity of developing countries and advanced economies.

(p.147) Excess Liquidity Set the Stage for the Crisis

Much of the blame for the hands-off regulatory environment that allowed excessive speculation and risk-taking to flourish in the decade before the crisis has been directed at central banks in advanced economies. But central banks also abandoned the quantitative tools of monetary policy—such as lending limits, and liquidity and reserve requirements—and allowed credit flows to respond to the pro-cyclical pressures of market forces. As they lost their ability to moderate the explosion in debt that unchecked credit expansion produced or to prevent the asset bubbles it fuelled, they helped create conditions that led to the crisis. The explosion in leverage that fed the massive increase in the volume of capital flows could not have occurred without the excessive liquidity they created.

The build-up in liquidity began in the aftermath of the collapse of the major stock indices in 2000. In its 2004 Annual Report, the Bank for International Settlements (BIS) called attention to quantitative measures such as the monetary base, broad money and credit to the private sector which had expanded rapidly since 1999 in a large group of countries. The resulting low interest rate environment intensified investors’ so-called “search for yield” and the unprecedented increase in the availability of funding spurred escalating amounts of leveraged speculation that narrowed risk premiums and eased credit standards. As the BIS correctly warned, a rising volume of leveraged speculation in domestic and international financial systems was fuelling credit expansion and creating unsustainable levels of debt in the global economy (BIS Annual Report, 2003, 2004).

Leveraged Capital Flows Undermined Policy Initiatives

Sizable, pro-cyclical capital flows over the last two decades played an important role in weakening the impact of changes in policy rates on the availability of credit in financial markets in both advanced countries and emerging market economies. In the US, for example, the Fed’s efforts to revive credit flows and economic activity with infusions of liquidity and lower interest rates were undermined by capital outflows during the recession in the early 1990s. As interest rates fell, the search for higher yields by domestic and foreign holders of US assets prompted outflows—mostly to Mexico—that prolonged the recession. Credit growth resumed when the Fed raised interest rates in March 1994 and US and foreign investors returned to US assets, leaving Mexico in crisis (Federal Reserve System (FRS) Flow of Funds, 2006; US Department of Commerce, 2006). This (p.148) shows how increases in US interest rates, on their own, were not effective in curbing credit growth in the US, but had very negative effects on Mexico.

By the middle of the 1990s, the growth of cross-border carry trade strategies, triggered by interest rate differentials on assets denominated in different currencies, increased the amount of leveraged speculation by financial institutions and further undermined central banks’ ability to expand or curtail the transmission of liquidity to their national markets.2 From 2004 through to the first half of 2007, for example, borrowing reached truly massive proportions, both in the US and abroad. Rather than halt rising debt levels, the Fed’s increases in policy rates spurred foreign private inflows into dollar assets by encouraging carry trade strategies that borrowed low interest rate yen to purchase higher yielding dollar assets.

Thus, the pattern that has developed over the last two decades suggests that relying on changes in interest rates as the primary tool of monetary policy in advanced and emerging economies can set off pro-cyclical capital flows that tend to reverse the intended result of the action taken. As a result, monetary policy no longer reliably performs its countercyclical function and its attempts to do so by changing the policy rate may even exacerbate instability.

Capital Flows, Leveraged Speculation and Bubble Inflation

In the period 2004–2007, borrowing in international as well as national financial markets set new records in virtually every quarter. The majority of cross-border lending in these high-volume years were inter-bank loans and loans to financial institutions in offshore centres. Commenting on a particularly large surge in lending as early as 2005, both the BIS and the International Monetary Fund (IMF) warned that downward pressure on interest rates resulting from excessive global liquidity had created an environment in which borrowing for speculative purposes had come to dominate cross-border transactions (BIS, 2005, 2006; IMF Global Financial Stability Report (GFSR), 2005). The ongoing growth in borrowing by financial institutions within the financial sector underscored the extent to which rising financial leverage posed systemic risks to asset markets—symbolized by Long Term Capital Management’s failure in 1998.

Meanwhile, as capital flows into the US in 2005 rose to twice the amount needed to finance the current account deficit, the US assumed an entrepot (recycling centre) function for global markets. Excess flows into dollar assets triggered sizable outflows for investment in higher-yielding emerging market assets (US Department of Commerce, 2006). With (p.149) an excess of dollars from foreign capital flows on top of current account surpluses flooding their markets, central banks in these countries bought dollars to prevent their conversion into local currencies. Their sterilized intervention strategies moderated the build-up in domestic liquidity and helped mitigate the appreciation of their currencies.

But, needing to invest the dollars they had acquired, emerging market countries bought US treasury securities and other dollar assets and re-exported the problem back to the US. The accumulation of dollar reserves by these countries augmented the highly liquid conditions in US financial markets, exerted downward pressure on medium and long-term interest rates, fuelled another round of capital outflows from the US back to emerging markets and facilitated continued binge borrowing by US residents, possible mainly due to the deregulation of financial markets.

Rising liquidity and debt in the years from 2004 through 2007 reflected a new dynamic introduced by the advent of monetary easing after 2000: the generation of liquidity through the spillover effects of leveraged cross-border investment flows. The round-robin (circular) nature of those flows constituted a dangerous scenario that was bound to lead to crisis when uncertainty—for any reason—threatened the highly leveraged financial sector’s need for funding.

Meanwhile, the rising debt levels of private financial and non-financial sectors were threatening to burst the asset bubbles they had created. The housing bubble that had become apparent in the US and was to burst in the second half of 2007 was fuelled by an extraordinary growth in debt. Outstanding credit reached 352.6 percent of GDP by year-end 2007, up from 255.3 percent in 1997. The rise in household debt over the same decade (from 66.1 to 99.9 percent of GDP) was both a key indicator of the debt bubble and of the growing threat it posed for future spending as debt service took a larger share of disposable income. But the most dramatic development, and yet another indicator of the growth in leveraged speculation, was the jump in the debt of the US financial sector to 113.8 percent of GDP from 63.8 percent only a decade earlier (FRS Flow of Funds, 2007).

Lessons for Emerging and Developing Economies

As early as 2005, the BIS’ Quarterly Review expressed concern that record low spreads on carry trade investments in emerging economies could make these countries vulnerable to re-pricing if there were changes in interest rates. The IMF also warned that economic and market developments that (p.150) had reduced risks in the near term were storing up potential vulnerabilities for the future (IMF GFSR, 2005). Those vulnerabilities became abundantly apparent in the fourth quarter of 2008 in the aftermath of the largest reduction in international bank claims for a single quarter on record.3 As noted in the IMF’s April 2009 GFSR, the collapse of international financing had spread the crisis to emerging and developing economies.

The reversal in flows and the collapse in global trade hammered emerging economies and triggered an equally large (US$298 billion) drop in the foreign exchange deposits they held in external banking markets to offset the loss of credit from international banks (BIS, 2009; IMF GFSR, 2009). The scale of the credit collapse in late 2008 was intensified by the amount of leverage in the system. Inflated by leverage, capital flows to these countries in the period 2005–2008 increased their vulnerability as speculative objectives determined the size and timing of inflows, and distorted domestic prices and the distribution of credit. In addition, the rising volume of marketable assets in national and external markets increased the impact of the downward pressure on prices.

While financial systems in emerging and developing countries remain primarily bank-based, the tilt toward market-based systems in advanced economies and the international markets means that developing countries must participate actively (and be given space to participate) in making decisions about ways to impose effective constraints on leverage related to capital flows and in derivatives and commodities markets. Although reinstating capital controls would moderate some of the damage inflicted on recipient countries by pro-cyclical inflows, the overall stability of the global financial system is no less important to their well being and will require controlling the scale of leveraged speculation through curbs on hedge funds and other highly leveraged institutions that engage in the carry trade.

Moreover, all countries must also join in efforts to reinstate tools that monetary authorities need to implement countercyclical policy initiatives and channel liquidity more effectively over the business cycle. And, as has been apparent since the Mexican crisis in 1994, central banks in emerging and advanced countries must reassess the ways in which capital requirements are designed. Capital should protect financial institutions from the boom and bust pressures of pro-cyclical market forces, not act as a stimulus to excessive credit expansion or a conduit to insolvency.

Finally, it is clear that more—and more careful—monitoring of external markets will be necessary. Regulatory strategies must be developed that can reach into these large and critical markets that flourish outside (p.151) national borders and provide the stability needed to promote sustainable growth in the global economy. Whether or not national regulators have the ability to control the leveraged speculation that has dominated external markets in recent years is not clear. Eatwell and Taylor (2000) argue for establishing a global regulator. Discussion of this proposal is crucial, and should be undertaken as part of the effort to construct a framework that can constrain the damaging effects of excessive pro-cyclical capital flows (see D’Arista and Griffith-Jones, 2009).

Criteria and Principles for Financial Regulatory Reform

As discussed earlier, two broad principles—comprehensiveness and counter-cyclicality—need to be adhered to, so that financial regulation is effective in ensuring financial stability and avoiding crises. Since late 2008, there has been growing support from G20 leaders and finance ministers as well as from international regulatory bodies—such as the Financial Stability Board and the Basel Banking Committee—for these two principles. A key issue is the extent and way in which they will be implemented; in particular, will the implementation of new regulations be “cosmetic”, or will the measures taken be strong enough to deal with the market imperfections at the heart of the current crisis?

Furthermore, though we focus on the two basic principles of prudential regulation, there are other, well-established ones: consumer protection and restricting monopoly power. Suffice it to say that even these well established principles were not followed in recent years. The first of these functions, consumer protection, should be considerably enhanced to avoid the supply of toxic mortgages and highly risky investment vehicles offered to unsophisticated agents. Restricting monopoly power is also very important, as the crisis has shown that very large financial institutions are difficult to regulate (given their large power), are very costly (and may become impossible) to bail-out, and also are too big to fail because of their interconnectedness with the rest of the financial system.

Regulation has to be Comprehensive

One of the main causes of the current crisis is the fact that effective regulation covers a diminishing share of total capital and banking markets. In particular, in the USA and other developed countries, there was a massive shift of savings from banks to capital markets. By 2007, only 25 percent of the US financial system’s assets belonged to commercial banks, which is a (p.152) major change from previous periods. However, commercial banks were the only part of the financial system that was regulated on a global basis for capital requirements, and even that regulation was partial, as off-balance sheet mechanisms went unregulated. Investment banks were very lightly regulated, and had less stringent capital requirements, while other financial actors—like hedge funds—were not regulated at all. Off-shore actors are subject to no or very light regulation. As a result of these regulatory shortages, a massive “shadow financial system” was allowed to emerge, with no or little transparency or regulation.

Because of regulatory arbitrage, growth of financial activity (and risk) moved to unregulated mechanisms (structured investment vehicles—SIVs), instruments (derivatives) or institutions (hedge funds). However, though unregulated, those parts of the shadow financial system were de facto dependent on systemically important banks.

A clear example of when the lack of capital requirements led to excessive growth of unregulated mechanisms is in the case of SIVs. It is very interesting that the Spanish regulatory authorities allowed Spanish banks to have SIVs, but required them to consolidate these special purpose vehicles in their accounting, implying they had the same capital requirements as other assets (Cornford, 2008: interviews). This eliminated the incentive for such vehicles to grow in Spain, and thus prevented them from becoming a major problem for banks as SIVs were in the United States.

Unlike Basel I, Basel II requires banks to set aside capital to support liquidity commitments to these vehicles; however, such commitments have lower capital requirements for short maturities. A more comprehensive solution would be for all vehicles and transactions to be put on banks’ balance sheets; then there would be no regulatory arbitrage, as risk-weighted capital requirements would be equivalent for all balance sheet activities; furthermore, transparency could become more comprehensive.

In capital markets, there was little formal regulation for systemic risks, with the focus mainly on individual investor protection. Private actors, such as insurance companies, pretended that they were able to sell systemic risk insurance, like credit default swaps (CDSs). Some of those major insurance companies, like AIG in the USA, had to be rescued, as they essentially became bankrupt. This was because they did not have sufficient capital and reserves to fulfill contracts that had a massive amount of systemic risk. Indeed, no entity—except the government—is capable of credibly fulfilling such a contract once the crisis spread. Thus, the government not only became the lender of last resort, but also the insurer of last resort (see Mehrling, 2009).

(p.153) It is encouraging that the G20 Working Group on Regulation and Transparency (G20 WGRT) agreed in March 2009 that: “All systemically important financial institutions, markets, and instruments should be subject to an appropriate degree of regulation and oversight, consistently applied and proportionate to their local and global systemic importance. Consideration has to be given to the potential systemic risk of a cluster of financial institutions which are not systemically important on their own. Non-systemically important financial institutions, markets, and instruments could also be subject to some form of registration requirement or oversight.” The timeline for implementing this will be two years after the fall of 2009. In Lessons of the Financial Crisis for Future Regulation (IMF, 2009), the IMF takes a similar approach: “The perimeter of financial sector surveillance needs to be expanded to a wider range of institutions and markets. …”

While it is welcome that the G20 and the IMF recognize the need for regulating all systemically important institutions, markets, and instruments (which implies significant progress in relation to the past), it seems problematic to define “systemic importance” ex ante. For example, would Bear Stearns have been defined ex ante as a systemically important institution? Furthermore, the risk is that market actors will take advantage again of regulatory gaps, and that the de facto less regulated parts of the system will again create systemic risk. In this sense, we prefer the stronger statement of 14 March 2009 by Brazil, Russia, India and China (the BRICs) which calls for “all financial activities—especially those of systemic importance—to be subject to adequate regulation and supervision, including institutions that are in the shadow banking system … and strongly support … to intensify supervision of hedge funds and private pools of capital.”

Indeed, we believe that the task of defining equivalent regulation on assets for all financial institutions and activities, both for solvency and liquidity, is essential.4 To be more specific, all entities that invest or lend on behalf of other people—using other people’s money and providing some type of leverage—need to have both relevant transparency requirements and need to be regulated, especially as regards their leverage, but also their liquidity. Within institutions, all their activities need to have equivalent regulation. Therefore, institutions like hedge funds need to be brought into the regulatory domain, as do all off-balance activities of banks.

As regards comprehensive regulation of solvency, equivalent regulation of different actors, instruments and activities should especially refer to leverage, as excessive leverage has been such a major source of systemic risk. (p.154) However, as the longevity of funding is an important variable, it may be desirable to restrict leverage more (and thus require more capital) for assets funded by short-term liabilities. This will not just protect the solvency of financial institutions, but also encourage them to seek more long-term funding.

Persaud (2009) has argued that tying leverage requirements to maturity of funding will also encourage diversity of behavior amongst different actors, thus discouraging herding across different categories of financial actors, and contributing to financial stability. In this regard, he proposes that, whatever they are called, financial institutions with short-term funding should follow bank capital adequacy requirements. Those with long term funding, according to Persaud, could have a different long term “solvency” regime, that would take into account their long-term obligations and assets. This interesting proposal deserves further study. It is key however that the equivalent regulation of leverage, for all actors, instruments, and activities, is designed and implemented in a simple way, as complexity makes implementation difficult and may ease regulatory arbitrage. Separate and sufficient minimum liquidity requirements should be an essential part of regulation, an aspect neglected in recent years.

Specific steps have already been taken towards more comprehensive regulation; the US authorities are addressing regulatory gaps, for example in the oversight of entities that originate and fund mortgages. The US Treasury’s March 2009 plea for future regulation was clearly summarized by US Treasury Secretary Timothy Geithner (2009): “All institutions and markets that could pose systemic risk will be subject to strong oversight, including appropriate constraints on risk-taking.”

As pointed out above, there is a great deal of broad support—from the G20, FSF, as well as major governments—for comprehensive regulation, including of hedge funds and private equity. Furthermore, an influential and detailed European Parliament (2008) report argues that financial regulation should be comprehensive; it especially emphasizes the need to regulate hedge funds and makes specific recommendations to limit the leverage of hedge funds to preserve the stability of the EU financial system. However, though the resulting proposed European Commission Directive says it favors regulation of hedge funds and private equity, it is extremely weak de facto on direct regulation; for example, it proposes only to directly regulate, and require capital, from fund managers (which is minimal), and not from the funds themselves. This would de facto mean no direct regulation of hedge funds and private equity leverage, key sources of systemic risk.

(p.155) Reducing Information Asymmetries for Better Regulation

A key pre-condition for comprehensive regulation is comprehensive transparency of the relevant variables. Transparency also has advantages for other stakeholders such as investors, other market agents and macroeconomic authorities. The March 2009 G20 WGRT has been clear in endorsing comprehensive transparency and recognizing it as a pre-condition for effective regulation “in order to determine the appropriate degree of regulation or oversight, national authorities should determine appropriate mechanisms for gathering relevant information on all material financial institutions, markets, and instruments.”

OTC Derivatives

One example is the complex and totally opaque over-the-counter (OTC) derivatives, which have reached massive levels. Possible solutions would attempt to standardize such instruments and channel them through clearing house based exchanges, as Soros (2008) was among the first to suggest, especially for the US$45 trillion worth of credit default swap contracts; if transactions are not channeled through exchanges, those that hold the contracts do not even know whether the counterparties are properly protected with capital. This requirement of trading in either clearing houses or exchanges should be obligatory for all OTC derivatives. This would have the benefit of ensuring appropriate margin and capital requirements for each transaction, as well as many other advantages, including those of transparency.5

It is encouraging that the US administration moved forward in May 2009 by proposing the requirement that all “standardized” OTC derivatives be cleared through regulated central clearing houses (Financial Times, 14 May 2009, “Geithner in push on derivatives regulation”; US Treasury Press Release, 13 May 2009, “Regulatory Reform Over-The-Counter (OTC) Derivatives”). This would reduce the risk to investors of being dangerously exposed to a single counterparty. In the proposed plan, their regulated central counterparties (CCP) would impose robust margin requirements and ensure that customized OTC derivatives are not used as a means to avoid using a CCP. All OTC derivatives dealers and counterparties would be subject to conservative capital requirements. These “standardized” derivatives, estimated at present to represent the largest part of the market, would also have to be traded on regulated exchanges via electronic systems. Central clearers will be required to produce publicly (p.156) available data on trading volumes and reveal to regulators the trades of individual counterparties.

However, several concerns remain. First, exchange trading would only be made mandatory in the US for “standardized” derivatives, not all derivatives. Second, global coordination of transparency and regulation of derivatives is essential, as these markets are particularly global. Finally, if several competing clearing houses are created in the US, and even more internationally, these could increase risks.

Hedge Funds

Another somewhat related example of the need for increased transparency involves hedge funds. On this, there is a growing consensus—including in the hedge fund industry itself—that improved information on hedge funds and other highly leveraged institutions (HLIs) would also be valuable to investors and counterparties, as well as regulators. Griffith-Jones, Calice, and Seekatz (2007) have pointed out that it seems appropriate for hedge funds to report market, liquidity, and credit risk. It also seems essential that hedge funds report aggregate worldwide and country positions, the aggregate levels of leverage, especially the levels of long and short positions, and the level of trading.

It is also important to decide the frequency of disclosure and to whom such information is to be disclosed. Positions can be reported in real time or with lags. Although real time reporting would be more useful, it could be much more costly, though much of the information is already privately available. Real time reporting, if publicly available, can enhance market stability by encouraging contrarian positions; however, it also risks encouraging herd behavior if other market actors mimic the positions of large actors (see de Brouwer, 2001). One problem of fixed point in time disclosure is the risk of “window dressing” for such moments. It would seem best if information be made publicly available. It may be sufficient if positions are reported in aggregate by class of institution, e.g. bank, securities firms, hedge funds, other HLIs, etc.

It seems important to find an institution that would be efficient at collecting and processing such data in a timely manner without compromising confidentiality. The institution with the best experience of similar data gathering is the Bank for International Settlements (BIS). Although we have discussed issues of transparency and disclosure in relation to the most opaque actors (hedge funds) and transactions (derivatives), similar criteria need to apply to opaque parts of the banking system.

(p.157) Regulation has to be Countercyclical

The most important manifestation of market failure in financial markets through the ages has been pro-cyclicality. In fact, risk is mainly generated during booms, even though it becomes apparent during busts. Therefore, the time for regulators to act—to prevent excessive risk taking—is during booms. This needs to happen through simple rules which cannot be easily changed by regulators so that they will not be “captured” by the general over-enthusiasm that characterizes booms that have so often led to the dangerous relaxation of regulatory standards. Unfortunately, Basle II bank regulation does exactly the opposite. Particularly in the advanced approach, Basle II calculates required capital based on the banks’ own models. This perversely incorporates the inherent pro-cyclicality of bank lending into bank regulation—thus accentuating boom-bust patterns—and interacts with the use of mark-to-market pricing to accentuate asset booms with excessive leverage.

Countercyclical regulation implies that the traditional microeconomic focus of prudential regulation and supervision be complemented by a macro-prudential perspective, particularly by introducing explicit counter-cyclical features in prudential regulation and supervision that would compensate for the pro-cyclicality of financial markets. The simplest recommendations are to increase capital and/or provisions for loan losses during booms, and to avoid mark-to-market asset pricing from feeding on greater leverage, with countercyclical limits on loan-to-value ratios and/or rules to adjust the value of collateral for cyclical asset price variations. The requirement of a countercyclical perspective in prudential regulation would go a long way to address some of the major criticisms of Basle II. It also implies that financial institutions should be urged to adopt risk management practices that take better account of the evolution of risk over the full business cycle, and less sensitive to short-term variations in asset prices.

It is very encouraging that the G20 leaders, the Basel Committee, the April 2009 Financial Stability Forum (FSF) Report and several recent major reports on financial regulation—such as the United Nations (2009), De Larosière (2009) and Turner (2009) Reports—all very clearly emphasize counter-cyclicality as a key principle of regulation. The April 2009 FSF Report on Addressing Pro-cyclicality in the Financial System is particularly insightful and complete in addressing issues of pro-cyclicality (see the discussion in D’Arista and Griffith-Jones (2009), from which this chapter is abridged).

Countercyclical bank regulation can be easily introduced, either through banks’ provisions or through capital adequacy requirements. It (p.158) is important that countercyclical rules are simple, and done in ways that regulators cannot loosen the rule in boom times, when they can be captured, not just by vested interests, but also by the exuberance that characterizes booms. On the other hand, some flexibility may be required, especially to add requirements for more capital and/or other provisions when new more risky activities emerge.

Countercyclical Regulation of Non-banking Institutions: The Carry Trade

Some of the least regulated parts of the financial system may have some of the strongest pro-cyclical impacts, including on emerging economies. One such example is the role that hedge funds and other actors as well as instruments, such as derivatives, play in the carry trade. Speculative positions are taken, whereby there is borrowing in a low interest currency and investing in a high interest currency, when it is assumed that there is a strong correlation between both currencies, or if the high yielding currency is appreciating. The countries’ vulnerability is further increased by the fact that national companies borrow uncovered in low interest rate foreign currencies, benefiting even more in the short term due to the appreciating local currency. There is increasing empirical evidence that the carry trade has very pro-cyclical effects (for over- or under-shooting) on the exchange rates of both developed and developing economies, often with negative effects on the real economy.

UNCTAD (2008) describes how the carry trade contributed in a major way between 2004 and 2008 to the sharp appreciation of currencies that had high interest rates, including those of many developing countries such as the Brazilian real, the Turkish lira, the South African rand and the Korean won, as well as several Central and Eastern European currencies. This allowed large speculative gains. Dodd and Griffith-Jones (2006; 2008) provide in-depth analysis of the Brazilian and Chilean experience. The global financial crisis provoked a “flight to quality” spurred by increased perception of risk; as a result, there was a large unwinding of the carry trade, including in developing country currencies, as well as several problems and even bankruptcies of large companies in countries like Mexico and Brazil. Naturally, those countries, companies and individuals who had borrowed in foreign currencies were particularly hard hit.

Developing and emerging regulators can, on their own, attempt to restrict the activities of those involved in the carry trade, especially in boom times. This can be done by imposing minimum capital requirements on (p.159) derivative dealers and collateral (margin) requirements on derivative transactions. As discussed below, this regulation can even have countercyclical elements. However, it seems unlikely that developing countries (and individual countries in general) can totally or effectively regulate the carry trade on their own, given that such a large part of these transactions are carried out by internationally mobile actors, often formally operating from off-shore centers, with low or no regulation.

This is precisely the type of issue that needs to be dealt with globally. Currently, the FSF coordinates actions with national authorities, and eventually, a global regulator could do so. The significantly increased presence of several major developing counties in bodies like the FSF and the BCBS needs to be used to raise issues such as international regulation of the carry trade, which is of particular—but not exclusive—interest to developing countries.

For regulation to be comprehensive, there should be minimum capital requirements for all derivatives dealers and minimum collateral requirements for all derivatives transactions, so as to reduce leverage and lower systemic risk. Collateral requirements for financial transactions function much like capital requirements for banks. However, the 2009 FSF report emphasizes that regulators should ensure that collateral and margin requirements should be cycle-neutral, that is they do not decline in booms. An issue to explore is whether the regulation of derivatives’ collateral and capital requirements should go beyond this, and also have countercyclical elements. This would be desirable as it would imply that when derivatives’ positions, either long or short, are growing excessively (for example, well beyond historical averages), collateral and capital requirements should be increased.

In addition, prudential regulation needs to ensure adequate levels of liquidity for financial intermediaries to handle the mismatch between the average maturities of assets and liabilities inherent in the financial system’s essential role of transforming maturities, but which generates risks associated with volatility in deposits and/or interest rates. This underscores the fact that liquidity and solvency problems are far more closely interrelated than traditionally assumed, particularly in the face of macroeconomic shocks.

Reserve requirements, which are strictly an instrument of monetary policy, provide liquidity in many countries, but their declining importance makes it necessary to find new tools. Moreover, their traditional structure is not geared to the specific objective of ensuring financial intermediaries’ liquidity in the face of the inherent maturity mismatches in their portfolios. The best system could be one in which liquidity or reserve requirements (p.160) are estimated on the basis of the residual maturity of financial institutions’ liabilities, thus generating a direct incentive for the financial system to maintain an appropriate liability structure.

Currency Mismatches and Capital Account Regulations

In developing countries, these countercyclical measures should be supplemented by more specific regulations aimed at controlling currency mismatches (including those associated with derivatives operations). The strict prohibition of currency mismatches in the portfolios of financial intermediaries is probably the best rule (as discussed in Griffith-Jones and Ocampo, 2009). Authorities should also closely monitor the currency risk of non-financial firms operating in non-tradable sectors, which may eventually pose credit risks for banks. Regulations can be used to establish more stringent provisions and/or risk weighting (and therefore, higher capital requirements) for these operations, or a strict prohibition on lending in foreign currencies to non-financial firms and households without revenues in those currencies.

Complementarily, and as long as there is no international lender of last resort, international rules should continue to provide room for the use of capital account regulation by developing countries. Capital account regulations can, in fact, play a dual role. They can be used as a complementary tool of macroeconomic and domestic regulatory policy. But they can also help to improve debt profiles, and in this way reduce the risks associated with liability structures biased towards short-term capital flows.

In practice, capital market regulations segment domestic and international markets. Traditional “quantity” controls—of the type used in China and India (but being gradually dismantled in these countries, as in others before)—differentiate between residents and non-residents, and between corporate and non-corporate agents among the former.

Another option is to introduce price-based regulations that effectively tax inflows or outflows. Taxing inflows was the choice pioneered by Chile in 1991 and Colombia in 1993 using the mechanism of unremunerated reserve requirements (URRs) on capital inflows. Argentina and Thailand have also used this approach in recent years, and taxing financial (including external) transactions has been common in Brazil. The basic advantage of price-based over traditional regulations is their non-discretionary character.

A large literature on these experiences leads to five main conclusions. First, controls on both inflows and outflows can work, but the authorities must be able to administer regulation while closing loopholes and avoiding (p.161) corruption. Permanent regulatory regimes that can be tightened or loosened in response to external market conditions are probably the best option. Second, exchange controls and quantitative restrictions may be the best means to reduce domestic sensitivity to global financial cycles, as reflected in China’s and India’s avoidance of the Asian crisis in the late 1990s. URRs and similar measures may only have temporary effects on capital inflows (especially if they are not ratcheted up during a surge), but do seem to influence interest rate spreads. Third, URRs and other reserve requirements help hold down short-term debt, which is highly volatile, and thus a significant source of vulnerability. Fourth, and perhaps foremost, controls are a complement to sound macroeconomic policies, not a substitute for them. Fifth, for capital controls—as for domestic regulation—good data availability is essential.

Capital controls obviously have costs. During surges, they increase the cost of financing, which is precisely what they are supposed to do. Longer term costs are more important. They can discourage operations by foreign institutional investors who may act as market makers for domestic bond and stock markets.

Despite their advantages, capital account regulations were not widely used during the recent boom. The trend has continued towards capital account liberalization, reflected in the gradual liberalization that has taken place in China and India. Liability policies in developing countries have, however, played an important role in recent years, particularly prudential instruments aimed at mitigating currency mismatches and active liability management by public sectors.

Liquidity and Solvency

Reform proposals put forward by national and international regulatory authorities have included calls for banks to raise capital to offset losses and write-downs on assets that have fallen in value. In these discussions, capital is viewed as the sole cushion for financial institutions and their shrinking capital base is increasingly seen as a threat to systemic solvency. Moreover, the ongoing pressure on capital has impeded efforts to revive credit flows and restart economic activity. But despite growing recognition that the increase and decline in financial capital responds pro-cyclically to market forces and tends to exacerbate pro-cyclicality, the focus on capital as the primary macro-prudential tool in the global system over the last two decades has crowded out discussion of alternatives that could augment capital in protecting both the system and individual institutions.

(p.162) Reform proposals must now focus on ways to make capital as well as provisioning requirements countercyclical. But they must also include discussions of alternative macro-prudential tools that readily respond to countercyclical monetary strategies and can act as systemic safeguards across the credit cycle. These tools include dynamic provisioning, lending limits (including limits on total leverage) and liquidity, margin, and reserve requirements.

These alternative tools would enhance monetary authorities’ ability to stabilize both the financial system and the economy—an ability called into question by the current crisis. The severity of the threat to institutional solvency led many to question whether central banks could defuse the credit crunch and stem the decline in asset prices. In the US, for example, what had been viewed as a liquidity crisis had become a solvency crisis by the fall of 2008. A continuation of liquidity support was seen as necessary, but that support appeared to be of limited value in terms of either ending the crisis or moderating its current and potential negative impact on the real economy. Solutions increasingly turned to proposals for government intervention to protect the solvency of systemically important institutions by supplying capital.

But beyond the immediate issue of crisis management, the complementary roles of central bank liquidity as well as capital and holdings of liquid assets as cushions for private financial institutions remain critical issues for reform in both advanced and emerging economies. Moreover, the shift in savings and investment flows from banks to capital markets in advanced countries and the international financial system requires that the transmission belt for both regulatory and monetary policy initiatives be extended to reach all segments of the financial system.

The Role of Capital in a Market-based System

Assessments of the role capital plays in guarding the soundness of the financial system have tended to focus on the balance sheets of depository institutions. It should be noted, however, that before 1983, there had been no statutory basis in the US for proscribing the amount of capital banks were required to hold against assets and capital requirements had tended to be ignored in most other countries as well. With the threat of default and the proliferation of non-performing loans to developing countries in the early 1980s, the US Congress directed the Fed to set limits on banks’ assets in relation to capital and this, in turn, led to negotiations with other (p.163) developed countries that resulted in the adoption of the Basel I Agreement on Capital Adequacy in 1988.

But, as noted above, rules governing capital adequacy for banks have not provided the systemic protection that was expected. Because of the rapid increase in outstanding securitized mortgages and other asset-based securities as well as the explosive growth of derivatives, trading and investment in marketable securities has come to dominate the major national and international financial markets. However, as has been demonstrated repeatedly since the crisis erupted in the summer of 2007, marketability does not mean that an asset can be sold at the expected price—or even sold at all—and the wider applicability of fair value accounting associated with trading activity intensified the inherent pro-cyclical bias of the increasingly market-based global system.

One requirement of traded financial assets is that they be marked to market as prices change. Unlike bank loans held in portfolio at face value, such traded assets—including those held by banks—change the value of the capital held by an institution as their prices fluctuate. When prices fall, an institution is required to write down the value of its capital to reflect the change in the value of the asset. As the amount of credit channeled through capital markets expanded, capital charges applied to a larger share of total credit, exacerbating the pressure on capital as the sub-prime mortgage crisis spread. Thus, the greater applicability of market-based rules increased the likelihood that the credit crisis would deteriorate into a solvency crisis more rapidly than in earlier periods and affect a larger group of institutions in a wider group of countries.

Indeed, resulting threats to the solvency of systemically important non-depository institutions have made clear that the focus on banks’ capital position is incomplete. The role of capital in a transformed, market-based system is a parallel concern. Thus, there is need to systemically re-examine the role of capital and to ensure that the strategies and tools used to bolster the soundness of financial institutions apply equally to all engaged in the activity. But how much capital should be held by individual institutions and when are increasingly related to the level of liquidity in the system as a whole, as well as the level of their holdings of liquid assets.

Maintaining Liquidity in a Market-based System

As capital is a scarce resource that is automatically depleted when losses are written off, liquidity requirements were used by central banks and regulators as a critical tool to protect capital before deregulation eroded (p.164) their effectiveness. The Federal Reserve’s August 2008 call for investment banks to shore up their balance sheets with more liquid assets underscored its belated recognition that capital alone is an insufficient cushion against the threat of insolvency (Guerrera and van Duyn, 2008). However, the systemic nature of the current crisis suggests that efforts by individual institutions or sectors to increase their holdings of liquid assets may be ineffectual if the central bank is unable to inject liquidity into critical markets.

Designing a countercyclical regulatory system will require reexamining the role and effectiveness of liquidity requirements for individual institutions and sectors as well as the channels the central bank uses to provide liquidity. The shift from a bank-based to a market-based system has obscured the fact that the systemic cushion for the financial sector in the US before the 1980s was bank reserves. Creating and extinguishing reserves by undertaking open market operations was the primary tool that allowed the Fed—as former Fed officials phrased it—to lean against the winds of the credit cycle. It reflected an ongoing commitment to countercyclical monetary policy that had evolved within the Fed in its formative years.

In 1951, when US banks held 65 percent of financial sector assets and liabilities, their reserve balances with the Fed accounted for 11.3 percent of bank deposits and constituted a remarkably comfortable cushion for a segmented financial system in which banks loaned to other financial sectors with which they were not in competition. Fifty years later, however, the shift in credit flows away from banks and banks’ use of borrowed funds and strategies such as sweep accounts to reduce holdings of deposits subject to reserve requirements, had virtually wiped out that cushion. By year-end 2001, banks reserve balances had shrunk to 0.2 percent of their deposits and banks’ holdings of credit market assets had fallen to less than half the share they held fifty years before (FRS Flow of Funds, 2002).

Going into the current crisis, the missing monetary cushion weakened individual financial institutions and made them more vulnerable to stops in external funding. Borrowing and lending among financial institutions through repurchase agreements—another rapidly expanding market in recent years—ceased to be an efficient channel for distributing liquidity as institutions’ confidence in the solvency of their financial counterparties eroded. But the missing monetary cushion also impeded the Fed’s ability to provide liquidity to the system as a whole. Despite the number of lending programs it created and the run-up in its balance sheet to include a more than ten-fold increase in bank reserves over a four month period, success in addressing the collapse of liquidity in funding markets remained elusive. (p.165) Capital infusions also failed to revive a stable funding channel for the financial sector, and credit to the real economy remained blocked.

The Fed’s struggle to ensure a systemic reach for its efforts suggests that central banks should attempt to build a source of systemic funding within the monetary system that, like reserves, is renewable, and will be immediately available to all financial institutions in a downturn—especially those that have extensive counterparty relationships with others within the financial sector. While capital is and will remain a critical tool as a cushion against insolvency for individual institutions, capital alone cannot protect the financial sector as a whole in the event of a systemic crisis.

A new system-wide reserve management regime—that will take into account the reduced role of the traditional banking conduit for policy implementation and the increased integration of institutions and markets—is needed. Such a regime would require imposing reserve requirements on all financial institutions and authorizing the central bank to increase and reduce liquidity by supplying and withdrawing reserve accounts with the central bank held on the liability side of institutions’ balance sheets. This would restore the effectiveness of countercyclical monetary strategies—a reform no less important than the regulatory reforms we and others have proposed—and help mitigate the pro-cyclical impact of the rise and fall in financial capital.6

In summary, we argue that there is a critical link between liquidity and solvency; that liquidity protects solvency, and that financial stability will require reforms that include comprehensive, countercyclical regulatory and monetary strategies like those suggested here.



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(1.) We are grateful to Ariane Ortiz Marrufo and Stefano Pagliari for excellent research assistance.

(2.) Low interest rates in one national market provided an incentive for carry trade strategies that used borrowings in that currency to fund investments in higher-yielding assets denominated in other currencies.

(3.) This figure is for consolidated claims on an ultimate risk basis—that is, after taking into account net risk transfers related to credit derivatives, guarantees and collateral.

(4.) The technical aspects of calculating equivalent liquidity (e.g. reserves) and solvency (e.g. capital) requirements across different institutions and activities require further study, both by institutions like the BIS and the FSF, by national regulators, from both developed and developing countries, and by academics.

(p.166) (5.) It is interesting that Brazil, an emerging country, has been effective in using regulations and other measures to encourage derivatives to move to established exchanges (Dodd and Griffith-Jones, 2008).

(6.) For discussions of proposals to extend reserve requirements to all financial institutions, see Thurow, 1972; Pollin, 1993; D’Arista and Schlesinger, 1993; D’Arista and Griffith-Jones, 1998; Palley, 2000, 2003; and D’Arista, 2009. For a discussion of the liability reserve management regime, see D’Arista, 2009.